Financial Strategy: Death and Taxes

Terminal illness alters financial outlook. It may require more current income due to increased medical expenses or a change in lifestyle. Or perhaps transferring assets to loved ones and engaging in estate planning is foremost. In either case, minimizing payment of federal income taxes is likely to be one aspect of general tax planning in the case of terminal illness.

Unfortunately, terminal illness often prohibits continued employment. Consequently, depleting or liquidating investment funds, retirement plans, and insurance policies may become necessary to generate sufficient cash. It is important to understand the tax ramifications of these financial decisions. It is also important to understand the extent to which medical expenses may be deducted on a federal income tax return.

Income tax planning for the terminally ill involves four general areas: general income and deduction issues, insurance considerations, retirement planning, and the income tax consequences of estate planning.  

Income and deduction issues that may be of particular concern to the terminally ill

In general, the period of terminal illness brings with it severe new limitations on the ability to earn money. Further, medical expenses frequently increase. In each case, significant income tax implications are involved. Depending upon a number of factors, the manner in which assets are liquidated may affect the amount of income tax paid. In addition, be aware that the medical expense deduction is broader than most people realize. This deduction can be used to reduce tax liability.

A dying person may need to increase income in order to offset expenses associated with the  illness. In addition, if work is no longer an option, additional funds to cover living expenses become necessary. It may be necessary to liquidate investment, retirement, or insurance assets. Since we generally control when to recognize income or gain, generally there's also control when incurring income tax liability. In a diversified and varied investment portfolio, it’s possible to  liquidate loss and long-term capital gain assets first.

Unfortunately, some assets will create ordinary income, rather than the more favorable capital gain income. Indeed, for many people, a retirement plan will hold the bulk of their investment assets. Be aware that withdrawals from a retirement plan will result in ordinary income.

Deduction of medical expenses

Medical expenses are deductible to the extent that they exceed 7.5 percent of adjusted gross income. These deductions reduce ordinary income. Note, however, that the medical expense deduction is limited to unreimbursed medical expenses.

It is important to keep detailed records of medical expenses. The need for extra income during a terminal illness is often associated with the need for medical care. Note that medical expenses include such disbursements as transportation to and from a physician for medical treatment, long-term home care, and insurance premiums. Improvements to a residence necessitated by disability are also deductible to the extent they exceed any increase in value to the home.

Note that medical expenses in the year of death may be used as either an income tax deduction or an estate tax deduction, but not as both.

Capital losses

Generally, capital loss carry-forwards are lost upon death. If sufficient loss carry-forwards exist during a lifetime, an increased need for income would best be served by recognizing capital gain income, which can be sheltered by loss carry-forwards.

Tip:   Depending on filing status, a surviving spouse may be able to use the deceased's loss carry-forwards.

Insurance issues

In some cases, insurance policies may provide a source of cash for the terminally ill. For instance, it may be possible to access life insurance benefits by selling a life insurance policy to investors. (This transaction is commonly known as a viatical settlement.) In addition, someone may have access to payments from disability, health, or accident insurance provided by the employer. Income tax planning for the terminally ill seeks the best after-tax return on these insurance vehicles. This approach is twofold. First, the taxation of insurance proceeds must be considered. Second, compare the after-tax return available on all the various investments.

Viatical settlements involve the sale of insurance policy benefits to investors. Under a recent change in the tax law, amounts received from a life insurance contract on the life of a terminally ill or chronically ill person are excluded from gross income if certain requirements are satisfied. In addition, the sale or assignment of a life insurance contract to a viatical settlement provider is not taxed if certain requirements are satisfied. Accelerated death benefits and viatical settlements allow access to the death benefit while the ill person is still alive. The return to the viatical settlement provider is the difference between the discounted value paid for the policy and the full value of the policy at the time of death. This return to the viatical settlement provider can also be viewed as a transaction cost, in a sense; it is the amount that would otherwise go to beneficiaries. But beware: The cost can be as high as 25 percent.

Viatical settlement companies buy almost any type of life insurance policy (including term, universal, whole, and group). The policy must be in good standing, it can contain no prohibition against assignment, and it generally must have been in force for at least two years. Typically, one must produce a medical certificate attesting to imminent death. Payment is usually made in the form of a lump sum. The primary risk to the company involves determining life expectancy. Note, however, that a viatical settlement might jeopardize eligibility for Medicaid or welfare benefits.

Viatical settlements vs. liquidation of other investments

Viatical settlements are not taxed if certain requirements are met. Nevertheless, they might not represent the best approach. After considering financial needs and specific goals, compare the consequences of a viatical settlement with the total cost associated with liquidating some or all of other investment assets. Viatical settlements can provide access to cash that one might not otherwise have. However, if there are a variety of different investments, the tax and transaction costs of liquidating investments such as retirement accounts or investments may be lower then the total cost of a viatical settlement. Bear in mind that medical expense deductions may be wasted if sufficient taxable income is not generated.

Disability insurance

Disability insurance policies typically pay a percentage of your income if you become sick or disabled and unable to work at your occupation. If you pay the disability premiums, the benefits are not taxable. If disability insurance is provided through an employer, the benefits may be taxable if the employer paid the premiums and the premiums were not considered taxable income for you. However, the disability benefits will not be taxable if they represent merely a reimbursement of medical expenses, permanent loss or loss of the use of part of the body, or disfigurement. In general, one cannot deduct the premiums.

Retirement plan distributions

Retirement plan distributions are often necessary to maintain the standard of living for the terminally ill. But this creates two problems: first, distributions from qualified retirement plans are taxed at ordinary income tax rates; and second, taking such distributions sacrifices tax-deferred growth.

The good news is that the terminally ill are not subject to the 10 percent early distribution penalty, because they are treated as disabled. The bad news is that distributions from qualified retirement plans are taxed at ordinary income tax rates. Since our tax system is progressive, large annual distributions can increase the marginal tax rate for the year in which distributions are received. Thus, the tax cost of accessing these funds can be significantly higher. However, increased deductions from medical expenses or through charitable giving may offset part of an increase in tax liability. A strategy that liquidates loss investments or long-term gain assets may actually be preferable.

Transfer of tax-deferred retirement funds into a Roth IRA may provide a number of tax benefits, also. Distributions from a Roth IRA are tax-free. Thus, Roth IRAs can help to increase income stream without increasing tax liability. Of course, the transfer of funds to a Roth IRA may be taxable. Given an abbreviated life span, this is probably not a beneficial strategy. However, taxpayers with significant deductions may want to consider a shift of retirement assets into the Roth IRA.

Taxation of retirement distributions after death

The creation of tax-deferred growth is one of the major benefits of a qualified retirement plan. With appropriate planning, this tax-deferred growth can be passed on to beneficiaries of an estate. But to the extent that distributions occur during a lifetime, some of this tax benefit is sacrificed.

Estate planning considerations

Retirement planning can certainly have an impact on income tax position. In addition, estate planning goals should be coordinated with income tax planning.

Gifting can be used to eliminate or reduce assets that generate ordinary income. Why would you give away income-producing assets when you need a greater income stream? Well, you might wish to spend down retirement assets and pass on investment securities to loved ones. Accomplishing this task prior to death reduces taxable income. Furthermore, you are not taxed on the built-in gain in an asset when you give it away. Unfortunately, this type of gift has income tax implications for the gift beneficiary, since he or she will have to pay tax on the built-in gain if and when the asset is sold.

Charitable giving may also offer several tax saving opportunities. The charitable contribution is tax deductible (subject to certain limitations), so it can reduce taxable income. Giving an unproductive asset away while increasing income stream allows one to reduce tax liability. Further, a person also can give away a partial interest in property. For instance, certain arrangements allow continuing use of a property, such as a home, while currently making a gift of the value of the remainder interest. This strategy ensures use of a residence until death, yet it also provides a deduction against current income. Beneficiaries will not get the property when the person dies, but current use of the property is not diminished.

Adapted from material provided by Forefield Inc.